PROBABILITY CONCEPTS

Key concepts are described

Probability rules are introduced

Expected values, standard deviation,

covariance and correlation for individual portfolio returns are explained

Probability Terminology
Random variable: uncertain number Outcome: realization of random variable Event: set of one or more outcomes Mutually exclusive: cannot both happen Exhaustive: set of events includes all possible outcomes

Two Properties of Probability

Probability of an event, P(Ei), is between 0 and 1 0 P(Ei) 1 For a set of events that are mutually exclusive and exhaustive, the sum of probabilities is 1 P(Ei) = 1

Types of Probability
Empirical: based on analysis of data Subjective: based on personal perception A priori: based on reasoning, not experience

Odds For or Against

Probability that a horse will win a race = 20% Odds for: 0.20 / (1 0.20) = 1/4 = one-to-four

Odds against: (1 0.20) / 0.20 = 4/1 = four-to-one

Conditional vs. Unconditional

Two types of probability: Unconditional: P(A), the probability of an event regardless of the outcomes of other events, e.g., probability market will be up for the day Conditional: P(A|B), the probability of A given that B has occurred, e.g., probability that the market will be up for the day, given that the Fed raises interest rates

Joint Probability
The probability that both of two events will occur is their joint probability

Example using conditional probability: P (interest rates will increase) = P(I) = 40% P (recession given a rate increase) = P(R|I) = 70%
Probability of a recession and an increase in rates, P(RI) = P(R|I) P(I) = 0.7 0.4 = 28%

Probability that at Least One of Two Events Will Occur

P(A or B) = P(A) + P(B) P(AB) We must subtract the joint probability P(AB)

Dont double count P(AB)

Addition Rule Example

P(I) = prob. of rising interest rates is 40% P(R) = prob. of recession is 34% Joint probability P(RI) = 0.28 (calculated earlier) Probability of either rising interest rates or recession = P(R or I) = P(R) + P(I) P(RI) = 0.34 + 0.40 0.28 = 0.46 For mutually exclusive events the joint probability P(AB) = 0 so: P(A or B) = P(A) + P(B)

Joint Probability of any Number of Independent Events

Dependent events: knowing the outcome of one tells you something about the probability of the other Independent events: occurrence of one event does not influence the occurrence of the other. For the joint probability of independent events, just multiply

Example: Flipping a fair coin, P (heads) = 50%

The probability of 3 heads in succession is:

0.5 0.5 0.5 =0.53 = 0.125 or 12.5%

Calculating Unconditional Probability

Given: P (interest rate increase) = P(I) = 0.4 P (no interest rate increase) = P(IC) = 1 0.4 = 0.6 P (Recession | Increase) = P(R|I) = 0.70 P (Recession | No Increase) = P(R|IC) = 0.10 What is the (unconditional) probability of recession? P(R) = P(R|I) P(I) + P(R|IC) P(IC) = 0.70 0.40 + 0.10 0.60 = 0.34

An Investment Tree
Prob of good stock performance 30% Prob of good economy Expected EPS = $1.51 Prob of poor economy 60% 40% EPS = $1.80 Prob = 18% EPS = $1.70 Prob = 42%

70%

60%

EPS = $1.30 Prob = 24% EPS = $1.00 Prob = 16%

Prob of poor stock performance

40%

Expected Value using Total Probability

Using the probabilities from the Tree: Expected(EPS) = $1.51 = .18(1.80) + .42(1.70) + .24(1.30) + .16(1.00) Conditional Expectations of EPS: E(EPS)|good economy = .30(1.80) + .70(1.70) = $1.73 E(EPS)|poor economy = .60(1.30) + .40(1.00) = $1.18

Covariance
Covariance: A measure of how two variables move together Values range from minus infinity to positive infinity Units of covariance difficult to interpret Covariance positive when the two variables tend to be above (below) their expected values at the same time

For each observation, multiply each probability times the product of the two random variables deviations from their means and sum them

Correlation
Correlation: A standardized measure of the linear

relationship between two variables

Values range from +1, perfect positive correlation

to 1, perfect negative correlation r is sample correlation coefficient is population correlation coefficient

Correlation
Example: The covariance between two assets is 0.0046, A = 0.0623 and B = 0.0991. What is the correlation between the two assets (A,B)?

Expected Value, Variance, and Standard Deviation (probability model)

Expected Value: E(X) = P(xi)xi

Expected Value, Variance, and Standard Deviation (probability model)

Variance: 2(X) = P(xi)[xi E(X)]2

Standard deviation: square root of 2 = 0.1136

Portfolio Expected Return

Expected return on a portfolio is a

weighted average of the expected returns on the assets in the portfolio

Portfolio Variance and Standard Deviation

Portfolio variance also uses the weight of the

assets in the portfolio

Portfolio standard deviation is the square root of

the variance

Joint Probability Function

Returns RB= 40% 0.15 RB= 20% RB= 0%

E(RB)=18%

RA= 20%

Probabilities
0.60
0.25

RA= 15%
RA= 4% E(RA)=13%

CovAB=

0.15 (.20 - .13) (.40 - .18) +

0.6 (.15 - .13) (.20 - .18) + 0.25 (.04 - .13) (0 - .18) = 0.0066

Bayes Formula
Prob. of interest rate cut (C) 60% 70% 30% 20% 40% Prob. of no interest rate cut
Prob (C|G) = 42/(42 + 8) = 84%
Prob (C|G) = [Prob(G|C) Prob(C)]/Prob(G) Prob (C/G) = (70% * 60% )/ (42% +8%)

Good earnings (G) 42% Poor earnings (P) 18%

Good earnings (G) 8% Poor earnings (P) 32%

80%

Factorial for Labeling

Out of 10 stocks, 5 will be rated buy, 3 will be rated hold, and 2 will be rated sell. How many ways are there to do this?

10! 2,520 5! 3! 2!

Choosing r Objects from n Objects

When order does not matter and with just 2

possible labels, we can use the combination formula (binomial formula) Example: You have 5 stocks and want to place orders to sell 3 of them. How many different combinations of 3 stocks are there?

Choosing r Objects from n Objects

When order does matter, we use the

permutation formula:
You have 5 stocks and want to sell 3, one at a

time. The order of the stock sales matters. How many ways are there to choose the 3 stocks to sell in order?

Calculator Solutions: nCr and nPr

How many ways to choose 3 from 5, order

doesnt matter? 5 2nd nCr 3 = 10

How many ways to choose 3 from 5, order does

matter?

5 2nd nPr 3 = 60

Functions only on BAII Plus (and Professional)

Probability Functions
A probability function, p(x), gives the probability

that a discrete random variable will take on the value x e.g. p(x) = x/15 for X = {1,2,3,4,5} p(3) = 20% A probability density function (pdf), f(x) can be used to evaluate the probability that a continuous random variable with take on a value within a range A cumulative distribution function (cdf), F(x), gives the probability that a random variable will be less than or equal to a given value

Properties of Normal Distribution

Completely described by mean and variance

Symmetric about the mean (skewness = 0)

Kurtosis (a measure of peakedness) = 3 Linear combination of normally distributed random

variables is also normally distributed Probabilities decrease further from the mean, but the tails go on forever Multivariate normal: more than one r.v., correlation between their outcomes

Confidence Interval: Normal Distribution

Confidence interval: a range of values around an expected outcome within which we expect the actual outcome to occur some specified percent of the time.

Confidence Interval: Normal Distribution

90% confidence interval = X 1.65s 95% confidence interval = X 1.96s 99% confidence interval = X 2.58s
Example: The mean annual return (normally

distributed) on a portfolio over many years is 11%, and the standard deviation of returns is 8%. A 95% confidence interval on next years return is 11% + (1.96)(8%) = 4.7% to 26.7%

Standard Normal Distribution

A normal distribution that has been standardized

so that mean = 0 and standard deviation = 1 To standardize a random variable, calculate the z-value Subtract the mean (so mean = 0) and divide by standard deviation (so = 1)

Calculating Probabilities Using the Standard Normal Distribution

Example 1: The EPS for a large sample of firms is normally distributed and has = $4.00 and = $1.50. Find the probability of a value being lower than $3.70.

3.70 is 0.20 standard deviations below the mean of 4.00.

Calculating Probabilities Using the Standard Normal Distribution

Example 1 cont.: Here we need to find the area under the curve to the left of the z-value of 0.20.

Calculating Probabilities Using the Standard Normal Distribution

For negative z-value calculate 1 table value
Excerpt from a Table of Cumulative Probabilities for a Standard Normal Distribution

Calculating Probabilities Using the Standard Normal Distribution

Find the area to the left of z-value + 0.20: From

the table this is 0.5793 Since the distribution is symmetric, for negative values we take 1 minus the table value Probability of values less than $3.70 is 1 0.5793 = 42.07% With a z-table for negatives, F(-0.20) = 0.4207